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The Stochastic Oscillator was developed by George C. Lane and is a momentum indicator. It shows where the current close is relative to a defined high/low range over a predetermined period. As closing levels are nearer the previous highs or lows of the period, this shows “accumulation”. This is an indication of buying pressure (at highs) or selling pressure (at lows)..
Of the three types of Stochastic Oscillators: Fast, Slow, and Full, Fast and Full are the most commonly used. Let’s first discuss the differences between Fast and Slow Stochastic. As with the MACD, the Stochastic has a principle line, which is the %K. The secondary line is a smoother version usually based on a moving average.
Usual settings for the Fast Stochastic are 14 and 3. In the example below, you can see the difference between a faster moving stochastic and a slower more smoothed stochastic. This also illustrates the major drawback for the Fast Stochastic. In the following chart, even the smoother Fast Stochastic crossed the %D line almost 30 times. To further smooth, and reduce false signals, the Full Stochastic Oscillator was developed.
Unlike the Fast Stochastic, the Full Stochastic Oscillator uses three parameters. As in the Fast Stochastic, the first parameter used when calculating the Full Stochastic, is the number of periods used for the %K line. The last parameter is the number used to draw the %D line. The big difference is the middle number. It’s used as a "smoothing” factor for %K. This has a cascading effect on the Stochastic. Because the %K is smoothed so is the %D smoothed even further. This means the %K line gets plotted as a SMA of the original %K line. Here’s an example.
Don’t get worried here if you have noticed that the tope oscillator is labeled as Slow, even though it is a Full Oscillator. Because the Full Stochastic Oscillator uses a third parameter and is much more pliable than the others, you can use the “Full” version to create the Fast and the Slow Stochastic. Here’s an example, a (14, 3) Fast Stochastic is the same as a (14, 1, 3) Full Stochastic, labeled as a Slow Stochastic on our charts.
To create an actual Slow Stochastic in 4XCharts, always use a 3 in the center position, and then change the outside parameters to the number you want. In this example a (12, 2) Slow Stochastic is the same to a (12, 3, 2) Full Stochastic.
Well all this is fine, but how do you actually use a stochastic oscillator? In a nut shell, when the oscillator is below 20, conditions are considered oversold and when the oscillator is above 80 conditions are considered overbought. But like the RSI, a reading above or below these overbought/oversold conditions, did not necessarily indicate a turnaround was coming. Currencies can continue to gain even after the Stochastic Oscillator has risen above 80 and may likewise continue falling after the Stochastic Oscillator has fallen below 20.
Simply using the crossover of the %K and %D lines would result in many whipsaws and large draw downs on your account. The same would happen if you simply sold above 80 and bought below 20.
Just like MACD and RSI, looking for formations and divergence is the best way to use the Stochastic Oscillator. It’s best to look for these formations and divergence at overbought and oversold levels, increasing the likelihood that a turnaround is happening. Here is what one may look like.
If this looks familiar, you are thinking of “swing failures” that were introduced with the RSI, and you would be correct. Any indicator that is bound by 0 and 100 can be used to find swing failures, providing great entries.
Here’s an example, identifying different trade setups. To begin with, on the very left of the chart a swing failure correctly identifies the new down trend. An example of price remaining oversold for some time after reaching 20 is shown in the oval at point A. Also notice the double bottom at point B indicating that the move lower may not yet be over. However, at point C price headed much lower put the oscillator was unable to match the previous lows as it did at point B. This led to a period of consolidation before a swing failure at point D, with a corresponding break or resistance takes price lower and the down trend takes a break.
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